The market for collateralized mortgage obligations is slowly recovering after the banking regulators and the accounting standard setters reached its agreement on the treatment of these investments in a banks portfolio, but industry experts say that the dust has not settled for bankers, they warn the new headache is likely to be investments in structured notes.
CMO activity will probably be driven up by the OCC letter on structured notes, one investment trader told CFO Alert. I think that this is the latest case of regulators crying wolf about so-called risky investments.
The Office of the Comptroller of the Currency issued an industry warning July 21 in an advisory letter about banks use of structured notes. The agency said that some national banks, particularly community banks, have purchased structured notes without fully understanding the market, liquidity and cash flow risks they have assumed.
Industry experts worry that bank examiners will now be scrutinizing these investments in a banks investment portfolio, much like they did with investments in CMOs, causing bankers to back away from structured notes.
I dont think that Washington [banking regulators] has ever had any categorical notion of risk with CMOs, said another source. I believe that it is the same situation now with structured notes, they dont know what the risks areand they really are not that risky, the source said.
OCC disagrees. The agency said in its letter that the risks involved and the difficulty in assessing those risks make some types of structured securities inappropriate investments for most national banks. The determination of whether a particular instrument is appropriate depends on the banks ability to understand, measure, monitor and control that instruments risks consistent with banking circular 277, OCC said. BC 277 lays out guidance on risk management to national banks and federal branches and agencies engaging in financial derivatives activities.
Structured notes are considered derivatives by the agency because of their embedded forwards and options and are commonly issued by government-sponsored enterprises like the Federal Home Loan banks, Fannie Mae, Freddie Mac, Sallie Mae, and the Federal Farm Credit Bank. Multilateral development banks, some foreign banks and private corporations also issue structured notes.
The structured notes issue is a major concern for us now, said another industry representative. Some industry trade groups are now focusing on educating regulators about the risks of these notes to avoid any controversy. We are really asking the regulators if their concerns are warranted because these instruments are customized to meet the risk profile needs of the investor and the profile of the customer.
Bankers and industry advocates generally agree that structured notes should be evaluated on a stand-alone basis, rather than as a general instrument. They fear examiners do not have the knowledge about these investments and that the OCC letter may generate uncalled-for suspicions about the riskiness of these instruments.
This is just the next step by regulators to stir up unnecessary controversy, said another investment trader. Structured notes do not pose a grave risk to banks, and examiners should know that.
A good number of savings institutions are generally ahead when it comes to interest rate risk. The nature of the business makes them keep ahead. These securities and how they are structured is a nonevent.
Bankers, and especially traders, contend the CMO controversy created between the regulators and FASB is an example of unnecessary worry over certain derivative instruments and believe that regulators are prepared to initiate similar scrutiny over other instruments.